Short Guts : Profit From Low Volatility

Introduction To Short Guts Option Strategy

Short guts

The short guts is actually the opposite of the long guts options trading strategy. While the long guts involves the buying of in the money puts and calls, the short guts involves the selling of in the money puts and calls. But unlike the long guts which has an unlimited profit potential, the short guts has a limited profit potential.

Short guts – a credit spread

The short guts is created by the writing of an equal number of in the money calls and puts, with the same expiration date and derived from the same underlying security. Because of the writing of options, the short guts trade will result in a net credit.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Low volatility
Step 3 :Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Unlimited loss potential
Step 7 : Loss calculation
Step 8 :  Limited profit potential
Step 9 : Calculation of maximum profit for short guts strategy
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing a short guts trade
Step 12 : Exit Trade & Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

Perform economic, fundamental and technical analysis. An options trader must do research to find out that volatility  is expected to stay low in an underlying security. The options trader is looking out for an absence of meaningful events that will cause the underlying security to be volatile. For example, during the life of the short guts, there are no earnings announcements to be made. Little positive or negative news is expected in the economy and the underlying security. The trader should also perform fundamental analysis. This will help the trader to put an estimated intrinsic value on the price of the underlying security. With regards to technical analysis, the trader is looking for range bound patterns. Some of the charts an options trader will look out for in a long guts is:

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 : Outlook – Low volatility

The trader looking to establish a short guts is anticipating low or little volatility in the price of the underlying security over the life of the options written. When that happens, the written options will loses its time value and the trader can buy to close the options at a maximum profit.

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Step 3 :Study the option chain

Examine the options chain. Select the options to be used in the short guts. Take note of the option premium of these options as the premiums will affect the breakeven points in the strategy.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

At this stage, breakeven analysis should be performed. There are 2 breakeven points in a short guts strategy.

The lower breakeven point can be calculated as:

Strike price of put less net credit received

The upper breakeven point can be calculated as:

Strike price of call + net credit received

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Step 5: Understand Your Profit Zones

Short guts

After breakeven analysis is performed, the trader will understand where the profit zones are. The trade is profitable for prices between the breakeven points.

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Step 6 : Unlimited loss potential

The short guts has an unlimited loss potential because it involves the writing of naked calls. The writing of naked calls is not for the faint hearted as a wrong bet coupled with a significant price move will turn a trade in a huge loss for a trader. When a trader writes a call, a significant price move upwards will mean a huge loss. Theoretically, stock prices can move upwards infinitely. When a trader writes a naked put, a significant price move to the downside will mean a huge loss. The price of the underlying security in this instance can move to 0. Hence, writing naked options are a dangerous proposition unless a trader knows absolutely what he is doing. In summary, the short guts has an unlimited loss potential and risk.

More specifically, a loss occurs when:

-The price of the underlying security trading at a price point below the lower breakeven point.

OR

-The price of the underlying security is trading at a price point above the upper breakeven point

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Step 7 : Loss calculation

The loss is largely dependent on the price of the underlying security. Hence, the loss of the short guts can be calculated as:

  • Price of the underlying security – ( strike price of call + net credit) + commissions paid to broker

OR

  • Strike price of put – ( net credit + price of underlying security) + commissions paid to broker

Conditions for loss to occur

For a loss to occur, price of the underlying security must be trading above the upper breakeven point or the lower breakeven point.

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Step 8 :  Limited profit potential

Within a certain price range, the short guts trade will turn a maximum profit. However, that profit is limited. This range of prices at which the short guts experience a maximum profit is between the strike price of the written call and put.

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Step 9 : Calculation of maximum profit for short guts strategy

The maximum profit can be calculated as:

Net credit + (strike price of written put – strike price of written call) – commissions paid to the broker

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Step 10 : Calculate Risk & Reward Ratio

With appropriate stop losses in place, calculate the risk and reward ratio. This will give the trade a quantitative measure of the attractiveness of the trade relative to trades of a similar nature.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade : Executing a short guts trade

To execute a short guts trade, a trader will:

  • write 1 in the money call
  • write 1 in the money put

Options written are derived from the same underlying security and have the same expiration date but different strike prices.

The ratio of in the money calls to in the money puts is 1 : 1. Hence, even if a trader writes 100 ITM puts and 100 ITM calls, it is still considered a short guts trade as long as the above ratio is adhered to.

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Step 12 : Exit Trade & Record Trade In Diary

After the trade has been exited, the performance of the trade should be detailed in a diary or a journal. Reflection on the trade and comparison of the trade’s performance relative to others is an important part of being a trader. Over time, as a trader does this, he will make improvements to his trading algorithm to become a better trader.

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Example Of A Short Guts

TTT is trading at a price of $50. A trader decides to executed a short guts trade. He does so by:

  • selling 1 Jan 55 put @ $5.50
  • Selling 1 Jan 45 call @ $5.50

When he does so, he receives a net credit. This net credit is equal to:

($5.50 + $5.50) x 100 = $1100

Let us examine 2 scenarios, a scenario where the price of the underlying security stagnates and a scenario where the is a significant change in the price of the underlying security.

When the price of TTT trades at $50:

Beginning value Ending value Profit(+) or Loss(-)
Sell 1 Jan 55 put $5.50 $5 (+)$0.50
Sell 1 Jan 45 call $5.50 $5 (+)$0.50
Overall profit (+)$1

In this case , the short guts is will turn a total profit of:

$1 x 100 = $100

This is also the maximum profit of the trade when the price of the underlying security trades between the strike prices of the put and the call.

When the price of TTT trades at $100:

Beginning value Ending value Profit(+) or Loss(-)
Sell 1 Jan 55 put $5.50 $0 (+)$5.50
Sell 1 Jan 45 call $5.50 $55 (-)$49.50
Overall loss (-)$44

As you can see, when there is a significant price move beyond the breakeven points( above the upper breakeven point or lower than the breakeven point), there is a total loss of:

$44 x 100 = $4400

The larger the magnitude of the price move, the greater the loss.

Hence, a trader looking to establish a short guts trade is looking for low volatility conditions.

Short strangle, variable ratio write and short guts

Option strategies such as the short strangle and variable ratio write have very similar payoff diagrams to the short guts. All strategies mentioned here experience a maximum profit when the price of the underlying security is within a certain range.

Opposing Strategy

The opposing strategy to the short guts is the long guts.

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